WatchingTheHerd: August 2025

The federal budget deal enacted in July 2025 is generating ripple effects in virtually every state government not only due to cuts in specific federal programs that funnel dollars to states but due to underlying changes in tax rules that flow from federal tax forms down to tax forms at the state level. It is safe to say that most Americans cannot understand how FEDERAL tax changes flow down to STATE tax revenues because most Americans do not actually calculate their own taxes to develop a feel for how a change on their federal tax form ripples through to their state filing. This ignorance makes citizens prone to being misled a second time by state politicians seeking to use unexpected changes in STATE finances to trigger calls for MORE spending reductions at the state level.

As an example, a debate underway in Colorado will be analyzed.

Planning officials in Colorado are estimating the state will suddenly face a revenue shortfall of $1 billion dollars due to the recent federal budget deal. With no change at the STATE level in tax rates, tax rules and state spending, how does any change at the FEDERAL level suddenly create a $1 billion dollar shortfall?

There are five sequentially cascading factors that drive this impact:

The federal government CAN borrow money.
Most state governments CANNOT borrow money. Most states require their legislature to enact balanced budgets EACH YEAR with zero borrowing.
Most state tax codes BEGIN with Federal Adjusted Gross Income as their top line when calculating taxable income at the STATE level. This keeps state-level tax codes simpler and state tax forms easier to understand.
Any change in FEDERAL taxation policy that materially alters federal AGI immediately ripples downward to affect state-level taxable income in nearly every state.
Any change in federal tax rules that alters the TIMING of deductions has a magnified impact on federal AGI and thus state-level taxable income.

One of the changes included in the budget deal enacted in July 2025 accelerated the timing of deductions for research and development expenses for corporations. The stated purpose of this change is to encourage spending on research and development performed within the United States by allowing companies to write off 100% of the expense incurred each year on R&D in that year's taxes. Prior to this new bill, the existing tax rule which changed in 2022 required research and development expenses to be deducted over a period of five years.

But here's the first twist...

Did that tax rule CHANGE in 2022 as a result of legislation PASSED in 2022 under the prior Biden Administration? No. The change to a five-year write-off was actually included in the Tax Cuts and Jobs Act of 2017 passed during the first Trump Administration which set 2022 as the year for the five-year scheme to take effect. This change was actually proposed BY the same lawmakers who pushed for the larger tax cuts included in that 2017 bill to help offset the loss of revenue from those larger tax reductions.

Here's the second twist...

The new budget deal enacted in July 2025 not only reverted the deductibility of domestic research and development spending back to 100% in the year of the expenditure, it included a provision for firms to "catch up" their prior R&D deductions for expenses in years 2022 through 2024. This further magnifies the timing shock imposed by this change in tax policy. Imagine a corporation spending exactly $1 million dollars in 2022, 2023, 2024 and 2025 under the tax rule prior to 2025. Each $1 million of R&D expense would have been spread out over five years from the year it was incurred. The total of $4 million dollars in deductions would have been spread out over nine years as shown below:

2022 -- $200k deduction for 2022(i) - $200k total deduction
2023 -- $200k deduction for 2022(ii) and 2023(i) -- $400k total deduction
2024 -- $200k deduction for 2022(iii), 2023(ii) and 2024(i) -- $600k total deduction
2025 -- $200k deduction for 2022(iv), 2023(iii), 2024(ii) and 2025(i) -- $800k total deductions
2026 -- $200k deduction for 2022(v), 2023(iv), 2024(iii) and 2025(ii) -- $800k total deductions
2027 -- $200k deduction for 2023(v), 2024(iii) and 2025(ii) -- $600k total deductions
2028 -- $200k deduction for 2024(v) and 2025(iv) -- $400k total deductions
2029 -- $200k deduction for 2025(v) -- $200k total deductions
2030 -- $0 deduction

Under the restored "same year 100% deductibility" rule WITH the catch-up rule for the years 2022 through 2024, here are the deductions that same corporation could take beginning with 2025:

Note the total amount of deduction being claimed in both schemes is the same -- $4 million – but the TIMING results in significantly less taxable income in 2025 under the second scheme versus the first. In 2025, the corporation will have $2 million dollars less in taxable income than under the prior plan.

That isn't just a change to taxable income at the federal level. It flows through to the state tax return as well but now the state has a unique problem. If the state has dozens of similar companies residing within its borders who are all incurring similar $1 million dollar expenditures for R&D, that state suddenly has a short term cash flow problem. Suddenly, with less than one year's notice, its taxable income for these corporations will drop by $2 million per corporation. In Colorado's case with a flat corporate tax rate of 4.4 percent, the state's tax revenue will suddenly drop by $88,000 per corporation in this hypothetical example.

What about the real world? How big can this research and development tax credit get for a typical corporation? Technically, there's no limit on the amount, only restrictions on the types of expenses that can capture the credit. However, for technology firms and software firms developing new products, the R&D credit not only applies to tools and process changes invented to improve products but salaries of employees designing those systems. For high-tech companies, the R&D deduction can thus be tens of millions – even BILLIONS -- of dollars. A corporation designing a new application with a development team with fifty employees making $150,000 per year could deduct 50 x $150,000 or $7.5 million dollars from taxable income.

Note that at some level, the federal government which instituted this timing change is unaffected by the change in taxable income and resulting tax revenue from this change. Holding spending unchanged year to year, the drop in revenue from taxable income in 2025 can be covered by borrowing money until the following year. But the state government cannot technically borrow money across fiscal years. If it knows its 2025 budget is now unbalanced, it must balance its 2025 budget NOW.

Is this single timing rule change for R&D the single factor that is creating a $1 billion shortfall in the Colorado state budget? Clearly not. But there are other changes in the 2025 budget bill that were likely only discussed by the special interests that placed them in the bill whose impacts are now just being discovered across all fifty states. For states which mirror the federal tax code down to state taxation rules, when TIMING changes at the federal level create FISCAL budget problems at the state level, the only choices available are:

Using a designated "rainy-day" fund to smooth the shortfall into the next budget year
Attempt to pass legislation altering the state tax code and straying from mirroring federal tax code, adding complexity to state tax collection processes and annoying voters
cutting spending to bring it into alignment with lowered revenue forecasts

Some states with Consitutional mandates to run balanced budgets also have laws which impose mandatory, across-the-board spending cuts when such revenue shortfalls occur unless corrected by new spending or tax legislation. Since spending and tax legislation is EXTREMELY difficult to enact in modern, bitterly partisan times, this makes draconian spending cuts easier for politicians to justify versus having to explain their actual votes and priorities for new legislation on taxes or spending. This plays into the hands of "conservatives" whose real goal is to simply cut government spending until the government is powerless to do anything, including policing the streets or responding to natural emergencies.

The more fundamental point here is that this 2025 budget bill is not only triggering these fiscal fire drills at the state level but that the underlying net impact of these changes is a wash at best. A firm spending $1 million in R&D is already a large business that presumably will be around for the next 5-10 years if its "innovations" are producing anything of real value in the first place. Having that firm wait for five years to capture the tax benefit of that $1 million in spending should be immaterial to that company's bottom line, especially if they are spending $1 million dollars every year in R&D. They will be at a point where prior years' deductions are adding up to equal $1 million dollars anyway, essentially given them the full benefit on a year-by-year basis. Accelerating the deductibility is a one-time "goose" to earnings that will do nothing to boost a firm's long term financial performance. It is exactly the type of financial manipulation one would expect in a bill passed under Republican control.

WTH

WatchingTheHerd

Friday, August 01, 2025

Three Card Monte in the Tax Code